Rethinking Conventional Wisdom About 401(k) Loans

Americans could save as much as $5 billion a year — or $275 per household — by borrowing from their 401(k) retirement accounts instead of more costly consumer loans, Federal Reserve economists Geng Li and Paul A. Smith conclude in a recent Fed working paper.

Many households eligible for 401(k) loans “carry relatively expensive consumer debt that could be more economically financed via 401(k) borrowing… We estimate that such households could have saved as much as $5 billion in 2007 by shifting expensive consumer debt to 401(k) loans. This would translate into annual savings of about $275 per household — roughly 20 percent of their overall interest costs — with larger reductions for households that carry consumer debt at high interest rates or who hold larger 401(k) balances,” they say.

The key advantage of a 401(k) loan is that it reduces the need for paying interest to outside lenders. Indeed, since the “borrowed” assets are already owned, a 401(k) loan is really just a withdrawal coupled with a schedule of replenishing contributions (with interest). A secondary advantage is that the transaction costs are typically quite low. Nonetheless, many financial advice publications discourage 401(k) borrowing, “Some worry that 401(k) borrowing simply encourages over-consumption, undermining retirement savings goals either indirectly (via unnecessary consumption) or directly (via reduced regular 401(k) contributions or defaulting on repayments),” they acknowledge.

So why don’t people do this? “Risk-aversion, self-control problems, and confusion about the potential gains,” they say.

They suggest “better financial education,” specifically posing these four questions to a would-be 401(k) borrower;

1. If you did not borrow from your 401(k), would you borrow that money from some other source (e.g., credit card, auto loan, bank loan, home-equity loan, etc.)?

2. Would the after-tax interest rate on the alternative (non-401(k)) loan exceed the rate of return you can reasonably expect on your 401(k) account over the loan period?

3. Would you be able to make your 401(k) loan payments without reducing your regular 401(k) contributions?

4. Are you comfortable with the requirement to repay any outstanding loan balance within 90 days of separating from your employer, or pay income tax and a 10% penalty on the outstanding loan?

If a person answers yes to all four questions, then a 401(k) loan could be advantageous; otherwise, other options might be better.

Allowing households to repay 401(k) loans gradually even after they leave their jobs “could improve household welfare by reducing the risks of 401(k) borrowing,” the Fed economists said.

The Fed’s 2007 Survey of Consumer Finances found about 15% of eligible households had borrowed from their 401(k) accounts. The fraction has been steady since 1995, but a growing number of borrowers say they used to money to pay off other debt. Media reports suggest more families are borrowing from retirement accounts in the current recession, but the Fed data isn’t recent enough to illuminate that.

The tax code limits the size of 401(k) loans to the lesser of $50,000 or 50% of the vested plan balance. In general, loans must be repaid within five years, though loans for the purchase (not refinance) of a principal residence may be repaid over a longer period (e.g., 15 years). Repayments are typically made via payroll deduction, but outstanding balances generally must be paid within 90 days of separation from an employer.

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